Did Lehman Brothers’ Failure Matter?

By this point, it’s become conventional wisdom that the failure of Lehman Brothers last September was the catalyst for a massive selloff in the credit and stock markets and a general flight to safety from which the markets have yet to recover. Had the government found a way to save Lehman, the assumption has been, things today would still be pretty terrible, but we probably would not have seen the economy “fall off a cliff,” as Warren Buffett said this weekend.

In the past few days, though, a new meme has started circulating through the economics blogosphere, suggesting that Lehman’s failure actually did not wreak the havoc that everyone who lived through last September thought it did. This argument, which was floated by the well-respected macroeconomist Willem Buiter on Friday, is based on a paper from last November by the Stanford economist John Taylor, which purports to show (pdf) that the credit markets actually did not react all that badly to Lehman going under and that the crisis was really the product of market uncertainty about the effects of government action. Taylor’s conclusion is based on one piece of evidence: a graph of the 3-Month LIBOR—the interest rate that banks charge to lend to each other—which he says shows that the real terror in the credit markets didn’t emerge until well after Lehman Brothers failed.

Now, as soon as Lehman failed, market participants—that is, the people who were actually making the decisions that mattered—were near-unanimous in their assertions that it would have disastrous effects. So in effect, Taylor is saying that even though the people who were setting prices for things like LIBOR and the like believed that Lehman’s failure really mattered, they were in fact wrong. The problem is that the graph that Taylor relies on as his only piece of evidence (it’s on p. 16 of his paper) doesn’t demonstrate what he thinks it does. In fact, LIBOR rose sharply in the days just before Lehman failed—evidence that even the prospect of Lehman going under had people worried. It then dropped a little when AIG was rescued, but then went straight up again, so that in the seven days leading up to and just after Lehman’s failure, LIBOR nearly doubled. That’s hardly a sign of the market shrugging off the incident.

More important, Taylor’s assumption in his paper is that investors would have known right away how severe the repercussions of Lehman’s bankruptcy would be. But this is simply untrue—for whatever reasons (some suggest fraud, others panic), the hole in Lehman’s balance sheet was much bigger than people initially thought it would be, which meant that the losses its lenders suffered were much bigger than anticipated. (One study suggests that the chaotic nature of Lehman’s bankruptcy alone cost creditors tens of billions of dollars.) As the magnitude of the losses became clearer, so too did banks’ risk aversion, since Lehman’s failure seemed to demonstrate starkly the risks of lending to any other big financial institution.

In any case, no one is arguing that Lehman’s failure alone was responsible for investors’ flight from risk—Congress’s failure to pass the first version of the Treasury’s bailout plan certainly made things much worse. But it was the first, and crucial, moment in last fall’s market panic, a panic that crushed stock and bond prices and set off a negative cascade that spread to the real economy and which we are still suffering the consequences of. In this case, then, conventional wisdom seems to be right. And in thinking about what Lehman’s failure tells us about how we should deal with tottering financial institutions today, I think Paul Krugman put it well a couple of weeks ago: “The collapse of Lehman Brothers almost destroyed the world financial system, and we can’t risk letting much bigger institutions like Citigroup or Bank of America implode.”

This may seem like an academic debate. But it’s not, because those who want to convince us that Lehman’s failure was not a big deal are doing so in order to shape future policy. In other words, they are arguing that when it comes to institutions like, say, Citigroup, the government can, in fact, let them implode—which means, in practical terms, allow their creditors to be wiped out—without any disastrous effects. Maybe they’re right, but it’s an awfully big gamble to take on the basis of a single dubiously interpreted graph.